Even if your tax situation is fairly mundane and you have your taxes withheld at source, there are some events in your life that can generate taxes. Understanding the tax implications of these events ahead of time can help you plan your finances better, and can, in some cases, save you from paying taxes altogether.
Cashing out an Old 401(k)
If you have money sitting in a 401(k) plan from an old employer, you may be tempted to cash it out so you don't have to deal with it any longer. In fact, if the amount is less than $5,000 and you have provided no other instruction to the employer, they may cash it out for you. However, once funds leave the protection of a traditional 401(k), they become taxable and you may also owe a penalty on early withdrawal if you are less than 59.5 years old. To avoid this, have old 401(k) plans rolled directly into your new employer's plan or into an individual retirement account (IRA). There are no tax consequences of a direct rollover. If you have already cashed it out, you can avoid both tax and penalties if you re-deposit it to a new plan within 60 days. Of the withdrawal, 20% will be withheld for the IRS, so you will have to find those funds elsewhere to deposit the whole amount to the new plan. (To learn more, check out 6 Problems With 401k Plans.)
Selling Your House
If you have a significant capital gain on the sale of your main residence, you may be on the hook for taxes. The IRS allows you to exclude the first $250,000 ($500,000 for couples who own the house together and file jointly) of the gain from your taxable income, but in most cases, anything over that is taxable. If you have been depreciating part of your house for business or rental purposes, you may also owe back tax on the depreciated amount. To minimize the tax implications, work through the calculation of the gain with a tax professional to make sure that you are including all of your capital improvements and additions over the years, which forms part of your cost base.
Rebalancing Your Investment Portfolio
Many new investors are unaware of the tax implications of buying and selling in their portfolios. In non-retirement portfolios, you are required to calculate capital gains and losses on the sale of any securities, even if you reinvest the proceeds within the portfolio. Starting in 2011, brokers are required to report capital gains to the IRS to ensure that they are reported fully and accurately. The timing of gains and losses can impact the overall tax liability for the year, so ensure that you plan your sales strategically. (For related reading, see Selling Losing Securities For A Tax Advantage.)
Selling Your Collectibles
Most household items you buy for personal use decrease in value quickly, so that, when you sell them at a yard sale, for example, you have a loss. This loss is not claimable for tax purposes. However, some items, such as collectibles and artwork, appreciate in value over time. You are required to report the gain of the sale of these types of items, wherever you sell them. For example, if you have collected baseball cards since you were young and sell the entire collection for $5,000, you have a capital gain of $5,000 minus what you paid for the cards originally and any expenses you have incurred in managing, appraising or selling the collection.
The Bottom Line
There are many life events that can trigger tax consequences, and proper tax planning can save you a substantial amount of money. A tax accountant or lawyer can help manage the tax effects of major transactions. (For more information, read 7 Year-End Tax Planning Strategies.)